Description

Investment Thesis

LKQ Corp (LKQ) is a name that is likely very familiar to the VIC community.  It was written up by Chalkbaggery in 2016 and Seastreak just over a year ago.   There is great background info in both pieces. We thought it is worth a short update (at least to foster a bit more debate) due to the recent share price dislocation.  LKQ is a great business that has had many doubters due to longer-term trends of increasing collision-avoidance systems/autonomous vehicles. However, it was the recent earnings miss (due primarily to issues in Europe that we see as temporary) that has led to the large, recent drop in the stock.  Due to valuation, recent closure on a very accretive deal and temporary issue that the company should be able to fix, we think LKQ represents a very attractive (and timely) risk/reward at current levels

Company Overview:

We won’t spend too much time on the overview as there is already great information in previous write-ups.  LKQ breaks out their operations into three segments: North America, Europe, and Specialty.

1.    North America (~40% of rev)

-  Leader (by a wide margin) in distribution of alternative (i.e. recycled) collision parts, engines and transmission, and replacement auto glass

- One of the few companies that is fully integrated from auto salvage to sale at vehicle repair shops resulting in status as low- cost producer

- Value proposition to consumers and insurance companies is clear and end demand, due to collisions, should have a tailwind over the next few years due to an increased cars on the road (even with lower SAAR due to past sales being the driver)

- There is still plenty of room for growth as alternative parts utilized for collision are still relatively low

2.    Europe (~50% of rev – PF for recent acquisition)

-   Supplier of alternative aftermarket mechanical parts (i.e. not collision as in North America) to auto repair shops

-   Plenty of growth opportunities due to lower alternative mechanical part utilization in Europe vs. North America, as well as large consolidation opportunities

3.    Specialty (~10% of rev)

-   Distributor of new specialty aftermarket products in North America

-   Also sell parts and accessories to RV dealers

-   Specialty parts include wheels, tires, trailers, etc.

Recent Issues

In April the stock fell almost 20% after a disappointing Q1 earnings report.  While the stock has somewhat recovered, it is still down ~25% from its 52 week high.  The majority of the disappointment was focused on the European segment. The company has been ramping-up of new distribution center in the UK (facility called T2) that is taking the place of multiple distribution centers.  During the ramp, the company hired temporary workers, which resulted in a large hit to margins. Even though this transition was telegraphed to investors, the impact was greater than expected. At this point all of the temporary workers are gone, per management, and the company should see improving margins from this point.  Between the distribution center consolidation and further EU growth, we think this division could hit 10%+ EBITDA margins over the next couple years (vs. 7.3% in Q1 and 8.8% in 2017). This will clearly be a show-me story but we think the roadmap is pretty clear.

Valuation

In terms of valuation, we see LKQ trading at ~12.5x EPS on 2019 numbers.  The stock has historically traded at 15-17.5x EPS and this is in-line with the most reasonable set of comps including the auto parts retail/distribution names (i.e. ORLY, AAP, etc.) and also KAR Auction Services (KAR) and Copart (CPRT).   As investors gain comfort that most of the European margin issues are temporary in nature, we think LKQ will, once again, return to historical multiples (which we think are more than fair considering the quality of the business). Using 2019 EPS, this gets us to a value range of ~$39-45/share or 18-38% upside.

Major Risks

• European margin issues are structural and UK distribution center issue was a diversion

• Biggest perceived risk is increased vehicle accident avoidance systems/autonomous driving.  Collision avoidance system usage (i.e. rearview cameras and blind spot detectors) is increasing but this also results in much more expensive replacement parts.  Our view on autonomous vehicles is that optimistic views of adoption are still extremely slow and we think it will be decades until there would be any material effect on the business.  This is obviously open to debate.

Catalyst

- Company showing improvment in European margins in earnings reports